Written by Barry Ward, Production Business Management Leader and OSU Income Tax Schools Director
Soon after the Tax Cuts and Jobs Act became law in December of 2017 it became evident that cooperatives had been granted a significant advantage under the new tax law. Sales to cooperatives would be allowed a Qualified Business Income Deduction (QBID) of 20% of gross income and not of net income. Sales to businesses other than cooperatives would be eligible only for the QBID of net income which was a significant disadvantage. Suddenly cooperatives had an advantage that non-cooperative businesses couldn’t match and most of the farm sector scrambled to position themselves to take advantage of this tax advantage. Some farmers directed larger portions of their sales or prospective sales toward cooperatives. Non-cooperative businesses lobbied for a change to this piece of the new tax law while looking for ways to add a cooperative model to their own businesses to stay competitive.
Congress passed the Consolidated Appropriations Act of 2018 in March of 2018 which eliminated this advantage to cooperatives and replaced it with a new hybrid QBID for sales to cooperatives which offered more tax neutrality between sales to cooperatives and non-cooperatives. While this new legislation leveled the playing field between cooperatives and non-cooperatives, it left many questions unanswered; chief among them was how taxpayers should allocate expenses between sales to cooperatives and non-cooperatives.
One area that was clarified for calculating the QBID for all businesses including cooperatives was how certain deductions should be handled with respect to the Qualified Business Income Deduction (QBID).
For purposes of the QBID (IRC §199A), deductions such as the deductible portion of the tax on self-employment income under § 164(f), the self-employed health insurance deduction under § 162(l), and the deduction for contributions to qualified retirement plans under § 404 are considered attributable to a trade or business (including farm businesses) to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.
Under the final regulations, expenses for half the self-employment (SE) tax, self-employed health insurance, and pension contributions must be subtracted from preliminary QBI figure, before any cooperative reductions are made (if applicable).
While final regulations on the new QBID were published on Jan. 18, 2019, there were still many questions left unanswered as to how the deduction would be handled in relation to cooperatives. As the QBID is calculated differently between the income from sales to cooperatives and non-cooperatives, taxpayers and tax practitioners were left with uncertainty.
A simplified explanation of the steps used to calculate the QBID under Internal Revenue Code (IRC) §199A for income attributable to sales to cooperatives is listed here:
Step 1: First, patrons calculate the 20 percent §199A QBID that would apply if they had sold the commodity to a non-cooperative.
Step 2: The patron must then subtract from that initial §199A deduction amount whichever of the following is smaller:
- 9 percent of the QBI allocable to cooperative sale(s) OR
- 50 percent of W2 wages paid allocable to income from sales to cooperatives
Step 3: Add the “Domestic Production Activities Deduction (DPAD)-like” deduction (if any) passed through to them by the cooperative pursuant to IRC §199A(g)(2)(A). The determination of the amount of this new “DPAD-like” deduction will generally range from 0 to 9 percent of the cooperative's qualified production activities income (QPAI) attributable to that patron's sales.
Parts of the new tax law do offer some simplification. Calculating the QBID isn’t necessarily one of those parts.
The result of all of these calculations is that income attributable to sales to cooperatives may result in an effective net QBID that is:
- Possibly greater than 20% if the farmer taxpayer pays no or few W2 wages and coop passes through all or a large portion of the allocable “DPADlike” deduction
- Approximately equal to 20% if the farmer taxpayer pays enough W2 wages to fully limit their coop sales QBID to 11% and the coop passes through all allocable “DPADlike” deduction
- Possibly less than 20% if farmer taxpayer pays enough W2 wages to fully limit their coop sales QBID to 11% and the coop passes through less than the allocable “DPADlike” deduction
On June 18th, the IRS released proposed regulations under IRC §199A on the patron deduction and the IRC §199A calculations for cooperatives. The proposed regulations provide that when a taxpayer receives both qualified payments from cooperatives and other income from non-cooperatives, the taxpayer must allocate deductions using a “reasonable method based on all the facts and circumstances.” Different reasonable methods may be used for the different items and related deductions. The chosen reasonable method, however, must be consistently applied from one tax year to another and must clearly reflect the income and expenses of the business.
So what “reasonable methods” might be accepted by the IRS? The final regulations (when they are provided) may give us further guidance or we may be left to choose some “reasonable” method in allocating expenses between the two types of income. Acceptable methods may include allocating expenses on a prorated basis by bushel/cwt or by gross sales attributable to cooperatives and non-cooperatives. Producers may also consider tracing costs on a per field basis and tracking sales of those bushels/cwt to either a cooperative or non-cooperative.
Included in the proposed regulations released in June was a set of rules for “safe harbor”. A taxpayer with taxable income under the QBID threshold ($157,500 Single Filer / $315,000 Joint Filer) may ratably apportion business expenses based on the amount of payments from sales to cooperative and non-cooperatives as they relate to total gross receipts. In other words, expenses may be allocated between cooperative and non-cooperative income based on the respective proportions of gross sales that fall to cooperatives and non-cooperatives.
Some questions that haven’t been answered clearly is how certain other income should be allocated between income from cooperatives and non-cooperatives. Tax reform now requires farmers to report gain on traded-in farm equipment. In many cases, farm income will be negative and all of the income for the business will be from trading-in farm equipment. The question is how do we allocate this income (IRC §1245 Gain)? Some commentators contend that none of these gains should be allocated to cooperative income which would eliminate the issue, however, the depreciation deduction taken on the equipment was likely allocated to cooperative income, thus reducing the effect of the 9% of AGI patron reduction. This would suggest that these gains may have to be allocated between cooperative and non-cooperative income.
How should government payments be allocated? If a farmer sells all of their commodities to a cooperative and receive a government payment (i.e. ARC or PLC), should that be treated as cooperative income or not. Hopefully, the final regulations will provide some further clarity on these issues.
The information in this article is the opinion of the author and is intended for educational purposes only. You are encouraged to consult professional tax or legal advice in regards to your facts and circumstances regarding the application of the general tax principles cited in this article.